How should you sell a public good?

Reed E. Hundt, Barry NalebuffJune 11, 2007

The airwaves are a precious commodity. More than 200 million cell phone subscribers in the U.S. alone chat and bat text messages across the wireless spectrum. When Reed Hundt was chairman of the FCC, he implemented the first auctions of this resource, opening the way for industry development and raising revenue for the government. Hundt recently talked with Professor Barry Nalebuff, describing what he learned about auction markets and how he might use an auction to save the environment. Of course, they spoke via cell phone.

Reed Hundt: Yes, I do. I knew that you would ask me that. I got it over the weekend, so I'd be prepared. And I would like to tell you that the iPhone reflects the failure of the spectrum auctions. The FCC, in 2001 and 2002, eliminated the spectrum caps and turned the auction policy from a pro-competition to a monopolization policy.

BN: Can you explain why spectrum caps matter?

RH: A spectrum cap means a limit on the amount of spectrum that one company can buy. Let's say that there's 400 MHz available. This produces a certain number of channels. In round numbers, most people would say that 20 MHz is the minimum, and 40 or 50 is desirable. Thus you will have at least eight competitors in the market if you limit any firm to 50 MHz. If you allow firms to buy up more, then they will, and you will end up with just a few competitors.

An essential principle in any auction of a limited but absolutely necessary commodity, whether it's oil or diamonds or spectrum, is to determine how much you're going to allow one firm to buy, because by making that decision, you're determining downstream market structure. You're determining whether you're going to have a monopoly, an oligopoly, or a competitive market.

BN: And so where are we now?

RH: The very, very short history is that before auctions were instituted 12 years ago, the overall decision was to have a two-firm market, and the two firms were AT&T and the local Bell. In 1995, yours truly, with the guidance of you, Michael Porter, Paul Milgrom, and a host of game theorists, auctioned spectrum under a spectrum cap that created a five-, six-, or seven-firm market, depending on the geography. Then, starting in 2001, the FCC reversed that and willy-nilly approved every merger that it got its hands on. The result has been to create a three-firm market. The three firms are Verizon Wireless, AT&T, and Sprint. While there are others, those three account for 80% of revenues.

The industry as a whole has gone from a very unconcentrated, very competitive industry to a very highly concentrated, consolidated industry. Typically mergers are blocked when the HHI [Herfindahl Hirschman Index] exceeds 1,800 — the industry is now at approximately 2,600.

The most obvious result of that is the following: When you buy an iPhone, you must acquire AT&T as your service provider. You have no choice. This is the only consumer electronics product in the United States that comes with a mandatory service contract with just one service provider. Number two, you get to pay, over the mandatory two-year term, three times as much to AT&T as to Apple. That is a glaring manifestation of the results of concentration.

BN: You bought an unsubsidized phone and you are still locked in for two years.

RH: Yes. And that has another twist to it as well. The so-called "lock rule" also means that the handset maker, in this case Apple, had to design the product to fit the technology standards chosen by the service provider, instead of the other way around. Verizon, with the freedom to lock out, was able to say to Steve Jobs, "We don't want you at all, and you have no right to get access to our network." And then, Jobs went to AT&T, who said "We'll take you, but the deal comes with all the following conditions, including a five-year exclusive."

Let me contrast this with all other consumer electronics. At Best Buy, RadioShack, or online, nobody at the retail level has the ability to say to the maker of consumer electronics devices, "We'll allow your product to go on our shelves, but our customers will have to commit to pay us three times what the product cost."

BN: I thought Apple was making money on the contracts with AT&T, that they were getting a cut of it. I had not appreciated that it's really AT&T who's benefiting at Apple's expense.

RH: Yes. There were two contrasts I wanted to make. The first contrast was to consumer electronics. The second contrast I want to make is to the way the cellular business works in China. In China, you buy any phone you want at a phone store. And then you go to the cellular service provider and you buy a card, and you turn on whatever phone you chose. Consequently, it's in China, not in the United States, that innovation in devices is exploding.

By the FCC's reverse of the 1990s market structure and the return to the 1980s market structure, the FCC has encouraged and permitted firms to create a bottleneck that is biased against margins in the device business, margins in the content business, freedom of choice at the consumer level. And you can argue — this is where you could debate — that there's no good outcome for the economy as a whole. It's only a good outcome for the shareholders of the bottleneck companies.

The one thing you have to admit — whatever side you're on in this discussion — is that there's nowhere to go after the next auction to buy spectrum to bypass the bottleneck. Because there is no new spectrum ever to be sold. As in the case of oil or diamonds, once this commodity is aggregated by the existing industry, there's no new place to go for an alternative business strategy.

BN: Just to understand the technology, are you saying that Apple could not have designed a phone such that you could plug in your SIM card from Verizon and have it work?

RH: The answer is yes. Verizon is capable of locking, and let me add that they are, in addition, capable of blocking. These are two different words here. They're not synonyms.

Verizon can block — not lock, but block — the content. That's because the Verizon network sees all the packets. So the choice is, on the one hand, lock and block — lock the device and block the content — or no-lock and no-block.

On the wire-line side, "no blocking" is a synonym for net neutrality, but "no locking" is the Carterfone Part 68 decisions of 20 years ago. We don't have either one of those two things. We don't have the Carterfone, and we don't have net neutrality. Consequently, on the front page of USA Today, today we have FCC chairman Kevin Martin calling for no locking but not no blocking. Consequently, what he said is meaningless, because if you don't have no blocking, then, when you connect your phone, Verizon could still say that you can't choose your own music.

BN: At least with no-lock I can take my phone to Europe, buy a GSM card there, and not pay outrageous fees while I'm traveling.

RH: You know, if your primary concern is Americans traveling in Europe, given the value of the dollar, it's kind of a small niche market that we're talking about.

In the fall, you'll be able to buy the iPhone in Europe, because they designed the iPhone for GSM, which is the AT&T network. But the big difference in Europe is that it should work six times faster. And the reason is that, in Europe, while they didn't use market structure as the means by which to force firms to create higher bandwidth networks — called a 3G network — they used absolute government mandates, instead. So when they auctioned the spectrum in Europe, they said, "If you buy this, you must build a 3G network." They accepted the more consolidated market, but they mandated a national — as it turned out, continental — 3G build-out.

If you're not going to trust the invisible hand of market structure, or if you're going to connive to say that you trust the market but then create a consolidated market, then the only antidote is to specifically mandate two things: a national "new build" of the 3G network, and, number two, a no-lock and no-block rule.

I hope you know that everything I'm saying is self-interested.

BN: Because of your position on the board of Frontline Wireless?

RH: Yes.

BN: So do you want to tell us a little bit about how Frontline is going to make our world a better place?

RH: Yes. First of all, in the next 30 days, the FCC will say either yes or no to the two essential rules for it. First, a national "new-build," and, second, a no-block, no-lock. And then, after that, if we raise the money and if we succeed in buying the spectrum, we're going to build a wholesale network. A no-lock, no-block wholesale network is a platform for retail competition and device innovation.

We would be the proprietors of the platform, and we would make money the way that the asphalt company makes money when somebody invents automobiles. That is, the car gets most of the money, but they do need roads.

Verizon's view is that it wants to have all the roads be toll roads, and it's going to decide where they go and how many lanes and how much you get charged. They will decide what trucks can go on it and what the trucks can carry.

BN: You're going to be a toll road, too. You're not giving the spectrum away. Other people are going to pay to use it.

RH: Yes, everybody is going to have to pay a fee, but the difference is with our business model and our proposed rules, we would have to take all trucks and anything that goes in them. Now, what I'm saying is exactly the same, conceptually, as common carrier. What I'm saying is the way the United States, 100 years ago, reacted to the emerging railroad monopolies — let's have common carrier as the rule. That's the way we reacted to containers and truck transportation. That's the way we had the telephone network configured. But the wireless spectrum auctions are on the verge of turning into the largest privatization of public property in the history of America, and an absolute red carpet to the re-creation of Ma Bell — but now we have twin Ma Bells: AT&T and Verizon.

BN: Let me see if I can take you on a different course. As the person who has brought auctions to government more than anybody else, where else would you like to see auctions being applied?

RH: I do not think that there is any public property that should be auctioned as long as we're in an environment where antitrust law no longer exists. There's no worse idea in policy than auctioning public resources in the absence of a guiding public interest philosophy that would include and not be limited to antitrust.

BN: How about global warming? Could you imagine an auction, or maybe a market, which could help solve this problem?

RH: Well, if I were going to auction something in global warming, what I would auction would be the following. I would auction the rights to supply the aggregated demand of public entities for energy.

I would aggregate as much as I possibly could aggregate in the categories of schools and libraries and police and government buildings and the Defense Department — everything that is a government user of energy, with a specific focus on buildings. I would aggregate all that, and I would say that I'd give this contract, on a long-term basis, to the entity that will provision energy, let's call it electricity for the sake of discussion, that will provision electricity with zero carbon emissions. I would auction that.

And by auctioning that on, let's say, a 15-year contract, I would have guaranteed the economic viability of some totally green energy option.

I would know, because it's an auction, that the people that bought it at least believed, in the auction environment, that they were going to have enough profit in there to provide the product.

BN: It's creating supply, not changing demand.

RH: Yes, it creates an alternative supply market. This would do more on the emissions issue than any plausible gas tax could ever do. The reason I say that is two-fold. First, consumer automobile transportation in America accounts for about one sixth of all emissions, whereas what I've described is a change in emissions as to a larger carbon footprint.

BN: Even a gas tax that reduced gas use by 10% would only lower total consumption by 10% on one sixth of all emissions, which is only a 1.6% reduction. But if you can influence how all the public energy buyers are supplied, that could have 10 times the effect.

RH: Well, one thing I will say about it, it's not a cap and trade, and while I'm not saying anything negative about a cap and trade, the deal that I just proposed is 100% guaranteed to be enforceable.

The other thing to say about it, and this is just a corollary, really, is that this is what the World Bank should do. What does the World Bank do? Let's be very unfair in making it simple. The World Bank helps fund infrastructure projects of many, many different kinds, all of which create carbon emissions. What the World Bank could do is become the purchaser of non-carbon-generated electricity, which it then handed over to the retailers of electricity in Kenya, Uganda, Zambia, fill in the blank.

Let me put it this way, instead of trying to have a global treaty that binds Africa and China, etc., which is extremely difficult to agree to and almost impossible to enforce, it's much better to have these very large, regional incentives. That's what the World Bank can do. All these treaty ideas are good things to do, but they are fundamentally punitive. They basically are saying, "Thou shalt not do x." And I'm telling you, that's going to be a tough putt.

BN: What do you think about guaranteeing the floor on the price of alternative energy?

RH: I think these other ideas are very well-intentioned, but simple and enforceable is really, really important. All the talk now is about how to punish the guy on the demand side, rather than how to use the demand side as a lever to drive a supply-side change.

BN: This is a carrot, rather than a stick.

RH: That's it.

BN: Your proposal is to reward people who supply. We can do a lot more using supply, because we can change a few people and make a big impact on supply, rather than trying to make a large number of people change the demand.

RH: Precisely.

BN: Thank you so much.

RH: Anytime. Bye.

Interviewed by Barry Nalebuff, Milton Steinbach Professor of
Management, Yale School of Management